Buybacks are effectively taxed at the same rate as dividends, at least qualified dividends, just timing differs:
Simple case with a corporation worth $200 with two equal shareholders, who each paid $100 for their half of the company and are in 20% capital gains tax bracket, ignoring net investment tax of 3.8%:
Dividends:
Corporation pays $100 in qualified dividends, $50 to each shareholder. Each shareholder pays their capital gains tax rate on the $50. If that rate is 20% for each, then a total of $20 is collected by the US Treasury. Each shareholder then reinvests or spends the remaining $80 in the economy, while the government puts the $20 to work.
Buy Back Case:
Corporation buys back $100 of shares from 1 shareholder. No taxes were due there as there were no capital gains for shareholder 1. Shareholder 2 now owns 100% of the corporation, so their investment is now, all other thing equal, worth $200. When shareholder 2 sells, a bill for $20 is due ( $100 in capital gains x capital gains rate ). Shareholder 1 reinvests/spends $100 in economy, government gets no additional cash now, but will eventually when Shareholder 2 sells.
In the end, government gets the same $20 in tax. Benefits of the buy back are that investors are able to choose whether or not they want to cash out, whereas a dividend forces it on all investors. Downside is that government has to wait for the $20 in capital gains taxes. However, if shareholder 1 owed capital gains on the buy back ( perhaps they bought their share for $50, so would owe $10 in the $50 it made on the sale ), the government would get $10 from that sale + $20 down the road when shareholder 2 sold.
Option three would be to not distribute cash through dividends or buy backs and reinvest directly in the business. In that case the net result and tax treatment is about the same as buying back shares. Trying to treat buy backs as a special case would just result in a defacto incentivization of conglomerates.
I’d rather invest in just that company, one that can continue reinvesting profits in itself at attractive returns year in and out. I can sit back and let compounding work it’s magic ( although at some point in my life I will switch from a net producer to a net consumer and opt for cash ). In cases where a company does not need all the cash it generates to continue its growth or does not have growth prospects ( not necessarily a bad thing), then I’d rather have cash to invest more productively elsewhere.
> Corporation buys back $100 of shares from 1 shareholder. No taxes were due there as there were no capital gains for shareholder 1. Shareholder 2 now owns 100% of the corporation, so their investment is now, all other thing equal, worth $200.
Maybe I don't understand how stock works, but wouldn't shareholder 2 still own only 50%, with the corporation still owning 50% of itself?
There is a disconnect here that needs to be clarified but you are actually part correct. The 'corporation' owns the shares, but shareholder 1 owns the corporation and thus it is his now. Shareholder 1 now owns 100% of the company but the company is worth 50% less because it spent half it's money on buybacks. So shareholder 1's value of ownership did not increase at all, only shareholder 1's % of ownership. Stock buybacks do not add value to a company and are not like a dividend at all. All they are is an indicator that the board thinks the shares are undervalued.
So...I know realistically, this isn't possible, but what if a corporation bought back every share except for one. Would that one lucky shareholder who probably bought his one share for $20 now own the entire corporation?
A stock buyback is not like the company is buying its own stock and holding it in a brokerage account.
Think about it like ... the opposite of an IPO. Instead of dividing up the firm into n shares and selling them to investors for cash; it's buying back n/m shares and effectively canceling them.
After the buy back, there are fewer shares of the company which are proportionately more valuable assuming the market capitalization has remained the same.
I looked up if a company can do the opposite - basically poof additional shares into existence and sell them - and found out they basically can and it's called stock dilution.
How is that legal? It doesn't make sense to me that if a share is worth x% of a company that said company can just decide "Nah, you actually now only own half of that" and sell more shares.
Fake edit: I googled "how is stock dilution legal" and found this [0] which explained it well and now it makes sense to me. The diluted stock might be a smaller % ownership, but since the company gained value because of money coming in, the dollar value of the shares stays the same.
No, the corporation retires the shares after the buyback. Total outstanding shares decrease. All remaining shareholders get a larger percent ownership of the corporation
The general principle is that unrealized gains are not taxed, but realized gains are.
If you are the seller from whom the company buys back shares, you pay taxes on your gain. If you’re a shareholder who doesn’t sell, you haven’t realized any gain.
Of course I understand that. But why it should be allowed to pay accumulated profits out from the company in a way that the taxes for share owners are deferred? What is the societal good of that?
Taxes for all shareholders are deferred until they sell. Taxes for all retail businesses are deferred until they sell their product. Taxes for all homeowners are deferred until they sell their house. Taxes for all art/collectible investors are deferred until they sell.
It’s a matter of practicality and fairness. (Don’t make someone sell an investment solely to raise the cash to pay taxes on an unrealized gain. Don’t create paperwork that’s unnecessary. The government is a patient investing partner. They’re willing to wait to take their cut when you sell. They can borrow arms-length money in the meantime far more cheaply than you can anyway.)
What would this look like from a practical standpoint, though? Dividends are a taxable event because you're giving someone money. In a buyback, the value of the stock simply goes up, which isn't a taxable event. How do you determine the cost basis on something like that? If there's a stock buyback over the course of 6 months, how do you determine which proportion of the price increase is due to the buyback, as opposed to inflation or normal growth?
In a buyback, a shareholder must sell shares back to the company. When they do, the shareholder's gains are taxed with capital-gains tax.
Furthermore, whenever shareholders sell shares after the buyback, their shares are generally worth more, so they pay increased capital gains, too.
I don't know which yields more tax revenue in the long run, but buybacks definitely generate some tax income.
The only time I could see a "buyback" influencing share price without taxation is if the buyback has a price cap, and every shareholder believes that the company is worth more, so they don't sell any shares back. This is exceedingly unlikely unless the company is very thinly traded.
From my perspective, the key difference with a buyback is the winnowing of shareholders to those who believe more-strongly in the company's future. With a dividend, every shareholder gets a small amount of cash. With a buyback, some shareholders get cash for their shares, and every other shareholder gets a bigger slice of a company that is worth less (total) money.
If the market is efficient (and it isn't, but it can be) then following a buyback, one would expect the market capitalization of the company to be smaller, as the company has paid out money. After 6 months, if the market cap of the company, plus the funds expended in the buyback, is greater than the inflation-adjusted pre-buyout market-cap, then the company has created shareholder value through some other mechanism (even if the mechanism is pure psychology).
>one would expect the market capitalization of the company to be smaller, as the company has paid out money
This doesn't make sense to me. If I spend $X to buy a widget worth $X, I've paid out money, but I haven't net lost anything. I'm worth the same in total. If the widget is a share in a company, even my own, that shouldn't change the fact that the net change in total value is zero.
When a company buys its own shares it’s essentially cancelling them: they become essentially worthless.
Look at if from a different angle: the ones selling the shares to the company are the shareholders. In aggregate, the shareholders own the company valued at $B (market cap) before the buyback, and the company valued at $A plus the cash paid $X after the buyback. If $A=$B they are creating $X out of thin air.
Even simpler to grasp: you have a business 50/50 with a partner. There is $1m in the company account, you reach an agreement and he will sell his interest back to the company for $1mn in cash. You are sole owner now. The company doesn’t have the cash anymore. How much was the company worth before? How much is it worth now?
> After 6 months, if the market cap of the company, plus the funds expended in the buyback, is greater than the inflation-adjusted pre-buyout market-cap, then the company has created shareholder value through some other mechanism
The mechanism may be called profit, earnings, free cash flow... at least for the old-fashioned companies that bring in more money that they spend over the six-months period.
I think it is mostly psychology via ratios. For example a number of institutional investors go by EPS. If shares in this industry are trading at a 20 x multiple and your companies shares are trading at a 10x multiple, you can try to buy back shares to get your multiple higher. Again, just one example but I'm sure the boards of directors, who are elected mainly by the institutional investors determine what will multiples and ratios they need to hit to be in the magic zone for algorithms and also investor psychology.
Buybacks get you a higher EPS number, I don’t see why would you expect the multiple to increase. But it’s true that there are many effects in play: signaling, offer/demand of shares, apparent improvement in ratios vs peers...
> If the market is efficient (and it isn't, but it can be) then following a buyback, one would expect the market capitalization of the company to be smaller, as the company has paid out money.
The company's cash flow is the same, but there are fewer outstanding shares, so earnings per share goes up. Earnings per share matters because when it increases that implies that future dividends per share will also increase.
If investors expect higher future dividends, that means that the stock is worth more, so it goes up.
You tax the buyback itself, right? You tax the money the company is spending on its own stock. That's the only step of the transaction where money is changing hands
Isn’t that a double tax? Taxed at buyback time, and taxed when shareholder cashes out and realizes their gain? Though I guess a small (10%??) tax could still make buyback tax + dividend long term gains is still less than normal income tax.
I'm not trying to be obtuse, I'm genuinely curious how this would work and what changes to tax law would need to be made.
Would you tax the entity buying the stock (in case always a company since it's a buyback; which I think would be the only example of taxing a stock purchase), or the entity selling the stock (either an individual or a company, which is already potentially taxed as capital gains)?
If the goal is to tax it similar to dividends you would tax the person selling the stock but it's already taxed as capital gains, either long term (0%/15%/20%) or short term (marginal bracket rate).
This is correct. Stock buybacks are just a way of doing dividends that is more tax advantaged.
The right answer isn't to introduce new forms of buyback taxes with unknown second-order effects (who would you tax? if the shareholder is avoiding dividend taxation, taxing the corporation isn't a great solution). The solution is to just improve the way we tax dividends and capital gains.
I agree with this entirely. If you tried to tax buybacks, you'd likely be inadvertently taxing a ton of the corporate infrastructure used for administrative purposes. In this case, the buyback is clearly like a tax-advantaged dividend, but with a key difference: it's not liquid. Dividends cross that critical threshold of spendable cash that triggers taxation.
If only 20 widgetshares exists in the world and we each have 50% (you have 10 and I have 10) and the market for widgetshares is $200.
Should you be taxed for your theoretical $5.26 gain if I destroy 1 widgetshare but you haven't sold any. Buy backs are no different. You will pay taxes if you sell.
Personally, I think you should pay taxes if you take out a loan using the market value of the shares as collateral. This is where everything starts getting funny and companies and individuals start being able to avoid taxes forever.
At the time of death, either make the estate pay capital gains taxes on the market value of the assets, or just don't give the heirs a stepped-up basis. It will catch up eventually.
No it's not as investors will have to pay taxes on any gains when they sell there stock which should happen in proportion to the buyback all else being equal. Buybacks just allow them to defer realizing those gains and paying taxes on them until they finally decide to sell.
I true for large or institutional investors, but not with 401ks and IRAs though. Also, for large institutional investors, they can time sales to use capital losses to avoid tax burden.
Ok so your original response to the comment is factually incorrect. Unless you think deducting capital losses and retirement accounts should be gotten rid of.
Another word for "a tax loophole" is "the tax law". The fact that ham fisted bureaucrats and legislators create unintended consequences with every "incentive" they put in the code makes it no less binding.
I don't remember what section of the IRS code or regulations cover it, but there are rules to prevent disguising a dividend as a stock buyback. They provide a good illustration of why the tax code is complicated.
(All numbers in the following are made up).
Some major company a long time ago was going to pay out a dividend, and then their accountants had a great idea. Instead of a dividend, they would first do 100 for 99 stock split. Then they would do a 1% stock buyback. The shareholders would be taxed at capital gains rates instead of ordinary income rates on this.
Note that for any shareholder, the result afterward is that for every 99 shared they owned before the split and buyback they still own 99 shares. No one's actual percentage ownership of the company has changed--but they have received money from the company.
The code and/or regulations were updated to fix this. But then buybacks that were not hidden dividends were getting classified as ordinary income, too, and so further code and/or regulation changes were made to further refine this.
What it eventually ended up with is rules that looked at how ownership was distributed among the shareholders before the buyback and after the buyback, and decided if it was a disguised dividend or a legitimate buyback based on how that distribution changed.
(I haven't followed tax law for several years. Anyone happen to know if this is still there after the Trump tax changes?)
This sort of thing is a large part of why tax codes and regulations tend to be big and complicated. Even if they start out fairly simple, people find holes like that split/buyback trick, and closing those holes adds complexity. The result is that you only generally will see either very simple tax systems (like sales taxes) or very complex systems. Systems that start out in between end up moving toward very complex.
